What Not To Do In Like-Kind Exchanges

The Internal Revenue Code (IRC) has long allowed taxpayers to use like-kind exchanges to defer taxable gains. That doesn’t necessarily mean a like-kind exchange will go unchallenged by the IRS, though. A corporate taxpayer learned this lesson when the agency — and two federal courts — found the company’s property transactions more akin to loans than like-kind exchanges.

Like-kind exchange options

Under IRC Section 1031, as recently amended by the Tax Cuts and Jobs Act, taxpayers can exchange business or investment real property (the relinquished property) for business or investment real property of a like kind (the replacement property) without recognizing any gain or loss until the disposition or liquidation of the replacement property. The most basic such exchange is the simultaneous swap of one property for another.

Sec. 1031 also allows a deferred, or “forward,” exchange where you transfer the relinquished property before acquiring a replacement property. And, in a reverse exchange, the replacement property is acquired and “parked” with an exchange accommodation titleholder before you transfer the relinquished property.

The taxpayer’s exchange attempt

Generally, IRS rules state that gains from the sale or exchange of property must be recognized in the year they’re realized — but they allow an exception for like-kind exchanges. However, to claim this exception, you must acquire a genuine ownership interest in the replacement property. Ownership for tax purposes isn’t determined by legal title. Rather, you must bear the “benefits and burdens” of property ownership. This was the primary issue in Exelon Corp. v. Comm’r — whether the taxpayer, an energy company, ever acquired genuine ownership of several power plants.

The taxpayer sold its fossil-fuel power plants for $4.8 billion, over $2 billion more than expected. Facing a hefty tax bill due to the $1.6 billion gain it realized on the sales, the taxpayer entered into several sale-and-leaseback transactions. In each, it leased an out-of-state power plant from a tax-exempt entity for a period longer than the plant’s estimated useful life, prepaying the rent upfront.

The taxpayer then immediately leased the plant back to the entity for a shorter sublease term. It also provided the entity a multimillion-dollar “accommodation fee” and a fully funded purchase option at the end of the sublease. The energy company characterized these transactions as like-kind exchanges for tax purposes.

The IRS and courts disagree

The IRS disallowed the tax benefits the taxpayer claimed from the transactions and determined the company was liable for an income tax deficiency of about $437 million. The U.S. Tax Court agreed with the IRS, finding the transactions didn’t transfer to the taxpayer a genuine ownership interest in the out-of-state plants. Like the IRS, the court found the transactions most closely resembled loans to the tax-exempt entities. Thus, the taxpayer wasn’t entitled to like-kind exchange treatment or the $94 million in deductions it claimed as lessor of the plants for depreciation, interest and transaction costs.

On appeal, the U.S. Court of Appeals for the Seventh Circuit noted that the subleases were “net leases,” meaning they allocated all of the costs and risks associated with the plants to the sublessees. That, along with each transaction’s defeasance structure and the circular flow of money, led to “the inescapable conclusion” that the energy company faced no significant risk indicative of genuine ownership during the terms of the subleases.

The court dismissed the taxpayer’s argument that it bore the “real risk” that the sublessees wouldn’t exercise their purchase options. According to the court, evidence in the case made clear that all of the parties to the transactions fully intended and expected the sublessees to exercise the options at the end of the sublease terms.

Construct with care

Like-kind exchanges are a valuable tax tool, but they’re not always as straightforward as they might seem. Consult with your financial advisor and attorneys to structure transactions that withstand IRS and judicial scrutiny.

The court in Exelon Corp. v. Comm’r (see main article) also affirmed the imposition of an $87 million penalty for the taxpayer’s underpayment of taxes. Its explanation demonstrates why appraisers must be allowed to reach their conclusions independently.

The taxpayer argued that it shouldn’t be subject to the penalty because it had relied on the advice of its legal counsel. Simply relying on a professional doesn’t necessarily relieve a taxpayer of penalties, though — the reliance must have been reasonable. Here, the taxpayer’s counsel supplied the appraiser with the wording of the conclusions it expected to see in the final appraisal reports. The U.S. Court of Appeals for the Seventh Circuit found that this tainted the appraisals and the taxpayer knew, or should have known, it was unreasonable to rely on legal advice based on the tainted property appraisals.

The taxpayer asserted that it had no way of knowing the appraisals were tainted in such a way. The court, however, found extensive evidence that the taxpayer knew its counsel was providing the appraiser with the desired conclusions.